It's easier than ever for investors to stock up on commodities

By James K. Glassman
Special to the Washington Post
Saturday, February 26, 2011; 7:00 PM

Commodity investing is suddenly all the rage. And no wonder. Demand for energy, metals, food and all sorts of other staples is booming as half the world - China, India and other developing nations - enters the ranks of the prosperous. In 2010, the price of oil rose 15 percent; gold was up 30 percent; corn, 52 percent; cotton, 89 percent.

Meanwhile, the United States, like other developed countries, has assumed huge amounts of debt since the 2008-09 financial crisis. Inflation - that is, a decline in the buying power of the dollar - seems inevitable. And when the value of a currency falls, then, by definition, the value of things bought with that currency rises.

Not only do commodities seem compelling, it is easier than ever for rank-and-file investors to buy them. Once viewed as exotic investments that were bought with high commissions and a lot of borrowed money (increasing risk), commodities today are packaged in easy-to-buy funds. For instance, with a keystroke, you can buy or sell iPath's Dow Jones-UBS Commodity Index Total Return ETN, an exchange-traded note with annual expenses of just 0.75 percent that tracks the index that appears in its name.

But not so fast. Asian prosperity does not guarantee that commodity prices will rise. Ultimately, prices are determined by supply and demand, and as demand rises, businesses make investments that increase supply. Firms explore new oil fields, open new mines or find synthetic substitutes (think rubber). Yes, there are constraints - some of them from environmental regulation - but the notion that natural resources will become severely limited in the long term is as flawed as the contention of Thomas Malthus in the early 19th century that population would outstrip food supply.

Consider corn, which soared to a price of about $5.25 per bushel at the end of 2010, up from about $1.50 at the end of 1970. Looks impressive, but the compound annual growth rate is only about 3 percent - roughly the same as the rate of inflation. By contrast, despite its poor record of the past decade, the Dow Jones industrial average has increased by a factor of 13 since 1970, and that doesn't count dividends.

Because commodities are things, you shouldn't expect their prices to increase at a rate much greater than inflation over the long term. The recent increase in the prices of many commodities may simply be a function of short-term speculation - much like what occurred in housing (another highly leveraged asset) before the roof caved in a few years back.

But what if we're on the verge of a new era of high inflation caused by all that debt and the currency-printing that has accompanied it? In that case, wouldn't commodity prices soar? Don't be so sure. Inflation would bring a jump in interest rates, so borrowing costs to buy gold and other commodities would rise; that would discourage purchases and maybe drive down prices. If you are worried about inflation, then buy protection through Treasury inflation-protected securities, whose returns rise directly with increases in consumer prices.

It's true that new financial products make commodities more accessible to retail investors. Exchange-traded funds and notes are much more sensible than futures contracts, which are promises to buy a specific amount of something on a specific date, bought with a tiny amount of equity and a huge amount of debt.

The performance of three major exchange-traded products that track commodities diverged wildly last year because of differences in their holdings. The best performer, the iPath ETN, returned 16.6 percent in 2010; next came PowerShares DB Commodity Index Tracking, which gained 11.9 percent; bringing up the rear was iShares S&P GSCI Commodity-Indexed Trust, which returned 7.8 percent. The index tracked by the iPath ETN has 27 percent of its assets in energy and 14 percent in precious metals. By contrast, the iShares product, which is geared to a Goldman Sachs index, has 66 percent of its assets in energy commodities and 3 percent in precious metals.

Probably the best reason to invest in commodities is that they have a history of being uncorrelated with stocks and bonds. When asset prices move out of sync with one another, the returns for your total portfolio are smoother.

A study by Rydex SGI compared the price movements of asset classes from the start of 2000 to the start of 2010. A correlation of 1.0 means that assets move exactly in tandem, while 0.0 means no correlation at all. The study found that international stocks have a correlation of 0.88 with U.S. stocks, indicating that their movements are tightly linked. But the connection between commodities and U.S. stocks was just 0.2.

It's hard to argue with the data. But in 2008, when large-company stocks suffered their worst loss since the Great Depression, with Standard & Poor's 500-stock index plunging 37 percent, commodities did almost as poorly. The PowerShares fund dropped 32 percent, and the others lost similar amounts. Perhaps 2008 was an outlier. Although the overall lack of correlation is encouraging, commodity funds just haven't been around long enough to provide confidence that they will balance your stock holdings in bad times.

Rather than buying commodities directly or investing in commodity funds, a better move is to buy stocks that are tied to commodities. Energy is the best example. If you believe in the case for booming growth in developing markets or for inflation, then buy shares of large companies that explore for petroleum, refine it and sell it.

If you want to speculate in a commodity that has not zoomed in price, look at forest products. While lumber has bounced back from its lows of last summer, it's still 32 percent below its 2004 high. Similarly, I am fond of companies that explore for and produce natural gas, which is suffering from a supply glut as new technology has boosted production.

The best natural-resources firms allow you to invest not just in things but also in brains. I would much rather entrust my capital to the human imagination - to our ability to find new processes, management techniques or arrangements of molecules - than to stuff in the ground.

!Daily James K. Glassman is executive director of the George W. Bush Institute in Dallas.

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